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Inflation: The Long View

David Purdy asks what 'inflation' actually means - and suggests that the issues it raises go beyond the need to simply support workers' demands for wage rises.

In his BBC Radio 4 series The Long View, the Guardian journalist Jonathan Freedland takes some salient event or topic in the news and examines it in the light of a relevant historical precedent or parallel. In what follows, after defining terms and clarifying ideas, I apply this method to the upsurge in inflation experienced across the world since the early part of 2021. In the G7 states, the rate of inflation has slowed down in the past six months, though it remains above official target rates and, in the UK, has proved harder to subdue than elsewhere. My aim is to drill down to the underlying causes of this economic malady, ponder its significance and consider whether there is a better way to tackle it than jacking up interest rates and risking a recession, a remedy that is scarcely better than the disease and may well be worse.

Defining and measuring inflation

The word 'inflation' is used nowadays to refer to almost any kind of price increase, including a rise in the prices of assets such as real estate, precious metals, famous works of art and rare antiques: Britons, for example, are obsessed with house-price inflation. I want to focus on the prices of newly produced goods and services and of the inputs of labour, energy, raw materials and semi-finished products required to produce them. It is these items that figure in computations of Gross Domestic Product (GDP), the standard measure in our world of what society finally gets from its members' combined productive activity. Accordingly, inflation can be defined as a sustained rise in the general price level. The key words here are 'sustained' and 'general'. To warrant the desciptor 'inflation', prices must keep on rising over time – at a steady or varying rate, as the case may be. And while the prices of individual products change all the time, this is consistent with overall price stability as long as increases in the prices of some items are offset by decreases in the prices of others.

To measure inflation, thus defined, we need a suitable price index. This involves classifying products, collecting data and processing them into a summary statistic: typically, a weighted average expressed as an index number: that is, relative to a baseline of 100, representing the price level at some time in the past. In the UK, this work is done by the Office for National Statistics (ONS), a state-funded, but independent public agency. The best known of the price indices compiled by the ONS is the Consumer Price Index (CPI), which measures the prices of goods and services purchased by households. Updated monthly, it is used to calculate the 'headline' rate of inflation and forms the focus of public debate about the cost of living.

Another, less well-known index of the general price level is the GDP price deflator. This has a broader coverage than the CPI which, by definition, is confined to those goods and services that enter private consumption. The deflator is calculated in the course of measuring GDP and converts GDP (also known as National Income) measured in current prices to constant prices, taking the prices prevailing in some base year as the standard of comparison. This removes the effects of inflation from the measurement and gives an estimate of real GDP as distinct from its nominal or money value. The index can also be broken down into four components – labour costs, import costs, net indirect taxes (i.e. indirect tax receipts less government subsidies paid to firms), and profits – each being measured per unit of final output (real GDP). This allows us to gauge the contribution each component makes to price rises in any given time period.

Accounting for inflation

In a particular year, higher unit labour costs might account for, say, 65 per cent of the rise in prices; higher import costs for 30 per cent; changes in net indirect taxes for minus 5 per cent (if, say, the government had reduced the rate of VAT or increased subsidies to mitigate the impact of inflation); and higher profit margins for 10 per cent. But because this kind of accounting breakdown is based on a definitional identity, it merely describes what has been happening in the economy and tells us nothing about the causal processes at work. Such exercises are not useless: they unpack the bare index numbers; and examining data for a run of years rather than for a single year taken in isolation may reveal trends and patterns that suggest causal explanations, though it cannot establish them.

Profit margins, for example, tend to fluctuate pro-cyclically, expanding in the upswing and shrinking in the downswing, but leaving the longer-term trend indeterminate. The rampant inflation of the 1970s was accompanied by a marked profits squeeze. This was subsequently reversed, yet until recently the period from the early 1990s onwards was one of moderate inflation. Indeed, in the mid-2010s governments and central banks were worrying about the prospect of deflation: falling prices or negative inflation. Of course, many firms, especially large ones, are price-makers rather than price-takers and are able to pass on increased production costs to their customers, though in doing so they have to reckon with the reactions of their competitors and what the market will bear. Some firms sometimes go beyond trying to rebuild or maintain their profit margins and engage in so-called 'price-gouging'. Such behaviour occasionally makes an impact on inflation, but in the larger scheme of things the part it plays is a minor one.

The same applies to net indirect tax receipts, which in a typical year account for only a small percentage of any rise in the price level. And some of this is a consequence of inflation since some indirect taxes – VAT, for instance – are proportional rather than flat-rate: hence, without cuts in the rates at which these taxes are levied, their proceeds rise automatically as prices rise. We can, then, conclude that the chief proximate sources of inflation are rising labour costs and rising import costs.

Import costs rise whenever the foreign currency prices of imports rise or the domestic currency depreciates, i.e., exchanges for fewer dollars, euros, yuan etc. than before. Substantial movements of either kind are intermittent rather than recurrent: the oil-price hikes of 1972-4 and 1978-80 are a case in point; so is the recent surge in global energy and food prices unleashed by emergence from lockdown and Russia's war in Ukraine, (the effects of which were exacerbated in the UK by the fall in the pound in the aftermath of Brexit). In short, rising import costs do not exert steady upward pressure on the general price level. Furthermore, the prices of internationally traded goods are entirely outside the control of the domestic government; and while the central bank can try to influence the exchange rate through its interest-rate policy, in a regime of flexible exchange rates its influence is limited.

Controlling inflation: the policy dilemma

Unit labour costs, by contrast, are thought to be susceptible to the influence of policy. That is why causal explanations of inflation tend to focus on the persistent tendency of money wages per worker to rise faster than output per worker (productivity). The implication for policy is that no anti-inflation policy can succeed which does not, by one means or another, close or narrow the gap between the rate of growth of money wages and the rate of productivity growth. In the short run, there is little scope for boosting productivity since the factors that determine it – technical innovation, business investment, methods of management, labour skills and workplace morale – change relatively slowly. The problem, therefore, is to find some way of restraining the rate of growth of money wages across the economy as a whole.

For those who recall the 1960s and '70s, this proposition will evoke memories of the prices and incomes policies pursued under successive British prime ministers from Harold Macmillan to Harold Wilson. But shorn of its historical associations, the proposition establishes no presumption in favour of any particular policy or kind of policy: it merely says that whatever policy is pursued will need to lower the rate at which money wages are rising if it is to bring a lasting reduction in price inflation. The alternative to some form of incomes policy is to rely on the impersonal discipline of the market, using monetary and/or fiscal policy to depress aggregate spending and with it, output and employment. Having driven itself into a tight corner, this is the course taken by the current British government, though one could describe its approach to public sector pay as an incomes policy that dare not speak its name.

There is no escaping the dilemma just outlined – not, at any rate, in the short run, (and in the long run, as Keynes famously observed, we are all dead). If we want to make the world a better place, there should be some recognisable connection between our short-term policies and our long-term goals: we should start as we mean to go on. In some respects, the problem of inflation resembles the problem of climate change. Both affect society as a whole, not just certain sections of it; both are rooted in our way of life, social relations and system of government; and viable solutions, if there are any, will have to be at once technically efficacious, ethically defensible, culturally acceptable and politically attainable.

It is entirely understandable that workers, whether in the public or private sectors, should demand pay rises that compensate for past or expected future increases in the cost of living. Economists call this phenomenon 'real wage resistance'. It may sound like the stuff of 'class struggle', but to the extent that employers accede to such pressure, the resulting pay settlements create problems for everyone else, especially in the UK's present straitened circumstances. For one thing, the groups best placed to protect their real incomes are those whose skills are in short supply or whose employers can pass on higher labour costs in higher prices: such is the logic of the market. And at the macroeconomic level, any sign of an emergent wage-price spiral, with money wages and prices chasing each other upwards, will simply prompt the Bank of England to tighten its monetary policy.

The underlying cause of modern inflation is conflict over distribution between workers, firms, government and taxpayers. Back in the age of incomes policy, attempts were made to resolve or manage the conflict within the framework of tripartite policy bargaining between central government and the peak organisations of employers and workers. In the 1970s, Swedish trade unions campaigned hard for parallel, complementary forms of 'economic democracy' at company and workplace level, but in the teeth of fierce resistance from employers, the project stalled. In the UK, the Bullock Report on Industrial Democracy, commissioned by the Labour government under the auspices of the Social Contract, set out detailed proposals for the election of worker directors to serve on the boards of large companies. The proposal was stillborn: most unions and almost all employers opposed it. Later, with the collapse of the Social Contract in the 'Winter of Discontent' of 1978-9, the very idea of social partnership was discredited and when, in 1983, the incoming Thatcher government dissolved its last remaining embodiment, the National Economic Development Council (NEDC or 'Neddy'), the event passed almost unnoticed. Elsewhere in Europe, the institutions of social partnership survived into the 21st century, but grew old and feeble. Perhaps the idea should be revived.

Written on 19th July 2023.

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